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CHAPTER 7. NEW BASIS OF ACCOUNTING. FOCUS OF CHAPTER 7. Recognizing a New Basis of Accounting The Push-Down Basis of Accounting Leveraged Buyouts. Push-Down Accounting: What’s Important—Form or Substance?. Rationale for Push-Down Accounting:

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chapter 7

CHAPTER 7

NEW BASIS OF ACCOUNTING

focus of chapter 7
FOCUS OF CHAPTER 7
  • Recognizing a New Basis of Accounting
  • The Push-Down Basis of Accounting
  • Leveraged Buyouts
push down accounting what s important form or substance
Push-Down Accounting: What’s Important—Form or Substance?
  • Rationale for Push-Down Accounting:
    • Relevant factor is the acquisition itself.
    • Form of the acquisition is NOT relevant.
    • Parent controls the “form of the ownership.”
      • Parent can ALWAYSliquidate the subsidiary into a branch/division.
push down accounting the 3 step implementation process
Push-Down Accounting: The 3 Step Implementation Process
  • STEP 1:
    • Adjust all assets and liabilities to current values (“cleanses” the target’s G/L of OLD BASIS).
      • Record GOODWILL as well.
      • Offsetting credit is to Revaluation Capital. (As always, capital is shown by source.)
push down accounting the 3 step implementation process5
Push-Down Accounting: The 3 Step Implementation Process
  • STEP 2:
    • Eliminate balance in the Accumulated Depreciation account.
      • Thus depreciation cycle begins anew.
push down accounting the 3 step implementation process6
Push-Down Accounting:The 3 Step Implementation Process
  • STEP 3:
    • Close out the balance in the Retained Earnings account to APIC.
      • Thus retained earnings starts afresh.
push down accounting when is it critical that it be used
Push-Down Accounting: When Is It Critical That It Be Used?
  • Theoretically: Whenever a subsidiary issues its OWN financial statements to externalusers.
  • GAAP Requirements:
    • Only the SEC mandates its use. (Only subsidiaries of publicly-owned companies fall under the SEC’s jurisdiction.)
    • The FASB has yet to require it.
push down accounting tastes great and less filling
Push-Down Accounting:Tastes Great And Less Filling
  • Push-down accounting:
    • Easy to implement.
    • Record-keeping is on one set of books instead of two.
    • Consolidation effort is easy as pie.
push down accounting why not used exclusively
Push-Down Accounting: Why Not Used Exclusively?
  • One of the great unsolved mysteries of accounting.
  • Inertia, stubbornness???
  • Clinging to “the way we have always done it”!
push down accounting is there hope on the horizon
Push-Down Accounting: Is There Hope on the Horizon?
  • YES! Practitioners tell us they are seeing it more and more.
leveraged buyouts a combination purchase refinancing
Leveraged Buyouts: A Combination Purchase & Refinancing
  • Basic Elements of a Leveraged Buyout:
    • Acquisition of a target’s assets or common stock.
    • Refinancing of the target’s debt structure—usually increased substantially.
    • Minimalequityinvestment by buyers.
leveraged buyouts let s get management in on the act
Leveraged Buyouts: “Let’s Get Management In On The Act”
  • An Additional Common Features of LBOs:
    • Existing management becomes part of the new ownership.
    • Existing management’s ownership is often as high as 50%.
      • Such LBOs are often called “MBOs.”
  • Advantage of Management Being Owners:
    • Alignment of interests occurs between management and remaining stockholders.
leveraged buyouts they are not business combinations
Leveraged Buyouts: They Are NOT Business Combinations
  • Business Combinations:
    • One active business combines with anotheractive business.
leveraged buyouts they are not business combinations14
Leveraged Buyouts: They Are NOT Business Combinations
  • Business Combinations:
    • A single corporation becomes the new owner of the target’s business.
      • This one legal entity now controls the target’s business.
leveraged buyouts they are not business combinations15
Leveraged Buyouts: They Are NOT Business Combinations
  • Leveraged Buyouts:
    • A group of investors (and often the target’s management) acquire either
      • The target’s assetsor
      • Some or allof the target’s common stock.
leveraged buyouts they are not business combinations16
Leveraged Buyouts: They Are NOT Business Combinations
  • Leveraged Buyouts:
    • After the buyout, the ownership of the target’s business may include any of the following groups:
      • New investors.
      • Management (at the same or a higherorlower level of ownership).
      • Former nonmanagement owners.
leveraged buyouts the change in control concept
Leveraged Buyouts: The Change in Control Concept
  • A new basis of accounting is allowed ONLY IF:
    • A change in control occurs.
  • To assess whether a change in control has occurred, the control group concept is used.
leveraged buyouts the control group concept
Leveraged Buyouts:The “Control Group” Concept
  • The control group can consist of:
    • New investors and
    • Prior owners who did NOT previously have control. Could include:
      • Management.
      • Nonmangement owners who owned less than 50% of the outstanding stock.
leveraged buyouts the control group concept19
Leveraged Buyouts: The Control Group Concept
  • BEFORE:
  • AFTER:
  • CONTROL GROUP: 30% + 45% = 70%

Management Nonmanagement

Owners Owners (one individual)

10% + 90% = 100%

Management Nonmanagement New

Owners Owners Investors

30% + 25% + 45% = 100%

leveraged buyouts manner of consummating the buyout
Leveraged Buyouts: Manner of Consummating The Buyout
  • Creating a New Legal Entity (NLE):
    • Investors create an NLE.
    • Investors invest cash in NLE.
    • NLE acquires target’s common stock or assets.
      • If common stock is acquired, NLE is merely a nonoperating company.
leveraged buyouts manner of consummating the buyout21
Leveraged Buyouts:Manner of Consummating The Buyout
  • Reasons for Creating the New Legal Entity:
    • Facilitates the change in ownership control:
      • Attaining the agreed upon ownership percentage of the various new ownersis much easier to accomplish.
    • Enables NEW BASIS of accounting to be used for target’s assets (GAAP compliance).
      • An important objective for most LBOs.
leveraged buyouts the key issue has a change in control occurred
Leveraged Buyouts: The KEY Issue—Has A Change In Control Occurred?
  • Significance of a Change in Control:
    • Enables use of a NEW BASIS of accounting for target’s assets.
    • New basis of accounting is highly

important for most LBOs.

      • Avoids reporting negativestockholders’ equity (NSE).
      • Reporting NSE to lenders is highly undesirable.
leveraged buyouts what constitutes a change in control
Leveraged Buyouts: What Constitutes a Change in Control?
  • The change in control must be:
    • Genuine
    • Substantive
    • Nontemporary
  • If not—no change in basis of accounting (record transaction as a recapitalization).
leveraged buyouts accounting for a change in control
Leveraged Buyouts: Accounting for a Change in Control
  • Types of Changes in Control:
    • No continuing ownership situations:
      • Enables 100% use of NEW BASIS of accounting (use Purchase procedures).
    • Continuing ownership situations:
      • Results in partial use of NEW BASIS.
      • Retains partial use of OLD BASIS.
      • Applying can be somewhat involved.
leveraged buyouts continuing ownership situations
Leveraged Buyouts: Continuing Ownership Situations
  • In continuing ownership situations, the accounting depends on whether the continuing ownership percentage(hereafter C-O-P)
    • Increases or
    • Decreases.
leveraged buyouts continuing ownership situations26
Leveraged Buyouts: Continuing Ownership Situations
  • C-O-P Increases:
    • Continuing owners are called bulls.
  • C-O-P Decreases:
    • Continuing owners are called bears.
leveraged buyouts c o p increases
Leveraged Buyouts: C-O-P INCREASES
  • Accounting Procedures:
    • Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners.
      • Called “carryover of predecessor basis.”
      • Ignore their personal cost basis.
    • Use NEW BASIS of accounting for the remaining ownership interest.
leveraged buyouts c o p decreases
Leveraged Buyouts: C-O-P DECREASES
  • Accounting Procedures:
    • C-O-P Is BELOW 20%:
      • Use NEW BASIS of accounting for entire transaction (with some exceptions).
    • C-O-P Is 20% or HIGHER:
      • Use OLD BASIS of accounting to the extent of the former ownership percentage that continues as owners.
      • Use NEW BASIS for remainder.
review question 1
Review Question #1

In push-down accounting, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

review question 1 with answer
Review Question #1With Answer

In push-down accounting, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

review question 2
Review Question #2

In recording a leverage buyout, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

review question 2 with answer
Review Question #2With Answer

In recording a leverage buyout, which accounts are adjusted to a zero balance?

A. Accumulated Depreciation.

B. Additional Paid-in Capital.

C. Retained earnings.

D. Revaluation capital.

E. Goodwill.

F. None of the above.

end of chapter 7
End of Chapter 7
  • Time to Clear Things Up—Any Questions?